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Shinnick: Market Doesn't Respect Value

Nadia Papagiannis, CFA

Nadia Papagiannis: Hello, my name is Nadia Papagiannis. I'm an Alternative Investment Strategist here at Morningstar, and today I have with me Mike Shinnick, who is the Portfolio Manager for the Wasatch-1st Source Long/Short Fund, which is a fundamental long/short equity fund.

Thanks for being here.

Michael Shinnick: Thank you for having me, Nadia. Good to be with you.

Papagiannis: Mike, today, this year has been a tough time for some long/short funds, especially the funds that take directional bets and shorts. Can you explain to us why?

Shinnick: Sure. Really, if you look back over the last couple of years, there have been some real dislocations in the market, I think we all know that. And so the very powerful recovery that we saw in stock prices last year abated really in second quarter after quantitative easing ended. Quantitative easing went from March '09 to March 2010, and if you look back that was a very strong period for equity returns. And we did exceptionally well during that period as many of the longs, actually their prices came back quite powerfully after that sell-off in the fall of '08, and many of the companies that had constrained balance sheets had problems and so many of the shorts worked there, particularly in early '09.

This year there has been much more correlation between the sectors and companies, so you'll have an up day and pretty much the whole market goes up, and then there are down days and pretty much everything sells off. And so in doing valuation work, we need there to be more separation in terms of quality, good-valued companies doing better than some of the weaker business models that are more overvalued.

Papagiannis: So what kinds of names are doing really well right now?

Shinnick: Companies that can still show growth. The market in our view is paying a premium for that growth, and more of the value-type names that on the long side were attracted to, frankly are not getting the P/E multiple or the valuation respect. And even though they're putting up very strong earnings, in many cases you're seeing these companies see their P/E multiples contract.

So there I'm talking about a company like a Microsoft or an Exxon or an Intel, literally nine, ten times right now with great balance sheets. The market is preferring to put multiples on companies that are showing 10 plus kind of top-line growth.

Papagiannis: So what you are seeing is a lot of people crowding into certain names, and you feel that these names are overvalued. So, can you talk about what you see happening in terms of your strategy looking you do as a result of this?

Shinnick: One of the things that we do, have done, or continue to do is stick to our process, and our process starts with macro, and our macro view has been and continues to be that we are in a recovery. The recovery has been questioned, particularly earlier in the spring with what happened in Europe. People said, "Ah, it's not going to work. There is double-dip." We think we are in a recovery, albeit a very muted and tepid one. We are not going to go back to these high rates of growth. But staying with high quality good-valued companies on the long side, we're going to continue to do that even if the market right now isn't as attracted to those stocks.

And then on the short side, there we have to stay patient, we have to stay flexible and it's much more about picking your spots, and we think there are overvalued situations particularly in some of the financials, some of these tech stocks that really have premium multiples, and some of the consumer cyclicals, which have had a very strong year this year.

Our view, because a lot of people simply aren't paying their mortgages, and I think there is increasing amounts of data to support that. Where if a household has stop paying on their mortgage, they are not necessarily saving or putting aside that money for getting a new place or renting. They are in turn using it to augment or supplement the family budget for dining out or travel or other things. But as we go through this continuing housing reset, there simply isn't going to as much money available on our view for many of these areas of consumer discretionary.

Papagiannis: Thanks so much for being here with us today, Mike.

Shinnick: Thank you, Nadia. It has been a pleasure.